Forex money management risk concepts
This lesson will cover the following
- What is the recommended Reward to Risk ratio
- How to use percentage risk method
- Learn about different types of risk and how to deal with it
Risk is defined in many ways in various sources. It is the variability of returns, amount of loss per trade, beta, maximum amount of loss per trade, volatility of prices, etc. Our concerns are pointed toward risk as a loss of capital. That would be our definition of risk and we will use the word “risk” with exactly the same meaning throughout this chapter.
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take, the greater the potential return. The reason for this is that investors need to be compensated for taking additional risk.
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Reward to Risk
The objective in all investment is to have a high reward to risk ratio. Return of investment, or ROI, is the standard way of calculating reward. ROI is calculated as net profit divided by initial capital at the beginning of the measured period. The standard method used for analyzing any trading portfolio and systems for reward and risk is to calculate ratio of ROI to the maximum possible loss.
Because of the risk-return trade-off, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking some risk is the price of achieving returns, therefore, if you want to make money, you cant cut out all risk. The goal instead is to find an appropriate balance – one that generates some profit, but still allows you to sleep at night.
What can be considered as a suitable risk/reward ratio in Forex trading? – 1:3 or 1:5 risk/reward ratio is achievable if you manage to enter a newly forming trend on time. Having earned enough experience, you should be able to spot the top and bottom of the trends, regardless of the time frame you are trading on. Even if you happen to enter at the middle of the action, the trend should still be able to provide another big movement so that you can make a profit which is 3 or 5 times bigger than your stop loss. However, there are a few problems.
1. Very often dont form a trend at all, instead they trade sideways
2. Some trends are not strong enough to ensure you a 1:3 or 1:5 risk-to-reward ratio if you enter them with delay during their middle phase
3. Very often the hesitation whether to enter a trend or not causes you to actually miss it and enter too late when the trend is actually ending and the price reversal triggers your stop loss.
A possible solution is to move the protective stop. It is advisable to not let your stop loss remain at its initial position, rather move it as the price action develops in your favor. Of course, each trader has to evaluate for himself how much to raise the stop.
Percentage Risk Method
The percentage risk method is a method according to which you risk the same fraction of your account balance as percentage per each trade.
The percentage risk money management method implies that there should be a constant percentage of your account balance that you risk per trade. In order to calculate it for each position you would want to enter, you need to have determined the risk you would want to expose yourself to and the size of the trade. Having those two at hand, you will be able to estimate where to place your protective stop.
As a trader, the number one risk is known as draw-down. Draw-down is the amount of money you have lost in your account on a single transaction.
If you have a $1000 account and you make a loss in a single trade of $50, then your draw-down is $50 divided by $1000 which is 5% draw-down.
The example below shows the difference between risking a small percentage of your capital compared to risking a higher percentage. Good money management requires you as a trader not to risk more than 2% of your total forex account equity.
|Trade number||Account Balance||2% Risk per trade|
|Trade number||Account Balance||5% Risk per trade|
|Trade number||Account Balance||10% Risk per trade|
The most important aspect of money management beyond establishing where and what kind of stops to use to protect capital is the determination of position size for each trade.
A larger position can incur unwarranted risk in case of failure including complete loss of capital and too little can reduce profit potential beyond risk free rate. Position size is directly related to capital risk (the amount of money that can be lost) and it is the aspect of money management that most traders and investors overlook.
It means the amount of capital committed to an investment that incurs a specific risk. Its usually based on the difference between the entry price and exit price multiplied by the number of shares or contracts.
Example: We assume we have $500 capital. Lets use a system which will buy an instrument at $50 and place a stop loss at $45. So, the $5 difference in price is the capital risk we are taking. The entire position is not at risk because it will be liquidated on the stop. If we dont use stops we have no idea what is the risk we are taking. This is one flaw of fundamental analysis which has no means to indicate when to exit a position.
Leverage, or the borrowing of capital to increase the potential of gains also increases risk. Risk is proportional to leverage. Leverage generally increases the volatility of the portfolio or system and thus magnifies all the dangerous possibilities from increased volatility such as larger drawdowns and more potential for complete ruin.
Pyramiding is a more complicated method of adding leverage to a position. It consists of adding to a position to gain leverage. Risks drastically increase because of the increased amount of investment locked into the position.
Trading and investing are largely psychological. The motion of investment vehicles is due largely to rational and to irrational decisions on the part of buyers and sellers. Taking advantage of this price motion is an emotional exercise for the trader. The participant in the market must be careful not to be swept up in the emotion of the crowd, in many cases he/she should act against the crowd which is against human nature. Outside interventions could affect the psychological wellness of the trader such as lack of sleep, family fight, sickness or lack of success. Unfortunately once lack of success begins, lack of confidence follows. The purpose of designing a system is to minimize those emotional factors and to help traders get back on track diminishing negative effects of it.
Diversification is the commonsense approach of “not putting all the eggs in one basket”. If different systems are used for diversification, they should not act in concert. Otherwise they are essentially the same system.
Risk is both correlated and uncorrelated. Correlated risk could be the risk that the Federal Reserve tightening the money supply will have a widespread impact on security values and impact almost any instrument. Correlated risk cant be reduced by diversification. Uncorrelated risk, however, can be diminished through diversifying ones portfolio and by this way reducing the effect of individual issues.
Ten losing trades in different markets is the same as ten consecutive losses in one market. The drawdown is the same. Thus, diversification could bring problems as well as reduce risk. The frequency of trading in different markets will increase the risk of a series of losses across markets.
Risk increases with time. The longer a position is held, the more risky it becomes. This is why long-term interest rates are usually higher than short-term rates. On the other hand, in the markets, reward does not increase with time. Thus, to reduce risk, a position should not be held beyond the time that reward ends. Then only risk remains.